What Is It?

An installment sale is a transaction in which one party sells an asset to another party. Rather than receiving the entire price at the time of the sale, the seller receives a series of payments spread out over time. For our clients from Southwest Gas Holdings who want to know how to qualify for an installment sales treatment, the seller must receive at least one payment in a year after the taxable year in which the sale occurred. An installment sale transaction is similar in some respects to a private annuity.

However, we'd like our Southwest Gas Holdings clients to understand that an installment sale is more flexible than a private annuity because the payments from buyer to seller can begin or end whenever the parties want them to. Unlike a private annuity, the payments under an installment sale do not have to continue until the death of the seller. A variation on an installment sale is the self-canceling installment note (also called the SCIN). With a SCIN, the seller takes back a note, and the buyer must make a series of payments to the seller under that note. There is a provision in the note that upon the death of the seller, the remaining payments will be canceled. The buyer should pay a premium for this self-canceling feature.

With a SCIN, there are complex income and gift tax considerations, so our clients from Southwest Gas Holdings to whom this applies, make sure to consider consulting an attorney for guidance. An installment sale can be an excellent estate-freezing strategy when the sale is between family members and involves rapidly appreciating assets, such as a family business or real estate. The installment sale will freeze the value of the asset for the seller (the older generation) for estate tax purposes and allow any future appreciation in the asset to be passed to the younger generation.

When Can It Be Used?

One Payment Must Be Made In a Taxable Year After Year of Sale

For our clients from Southwest Gas Holdings who want to know how to qualify for installment sale treatment, at least one of the payments of the installment sale must be made in a taxable year after the year of the sale. There is no requirement that there be a payment in the year of the sale. The seller of the asset has a great deal of flexibility in how and when the payments will be structured.

Payments May Be Deferred As Much or As Little As the Seller Desires

The seller of the asset may defer as much or as little of the payments as he or she desires. The seller has tremendous flexibility in setting up how much of the total sale price will be received in what year. As long as one of the payments is made in a taxable year after the year of the sale, then the seller can structure the payments in almost any fashion.

Example(s): You are 65 years old and own a successful business. You would like to retire and sell the business to your son, who has been working with you for the past ten years. You sell the business to your son for $1,000,000 in an installment sale. In the year of the sale, you have substantial other income, putting you in the highest marginal tax bracket. You expect to be in a lower tax bracket once you retire. You can structure the installment sale so that you receive either nothing or a nominal amount in the year of the sale and then spread the remaining sale price over any number of years that you desire. The payments could continue for 5 or 10 or 15 years. You have the flexibility to design the payment plan to fit your tax and other needs.

No Minimum Sale Price Required

There is no minimum selling price necessary for an installment sale. You could set up an installment sale for even a very low-priced asset. For example, if you sold a piece of land to your daughter for $10,000, you could structure a sale where the price is paid over ten years.

Installment Sale May Take Place Even If the Selling Price Is Contingent

You may set up an installment sale for an asset even if the selling price is contingent on some other event at the time of the sale. For example, you may sell your business to your two children, and the final sale price will be contingent on how well the business does over the five years after the sale. Such a sale is still eligible for installment treatment.

Installment Sale Treatment Is Automatic Unless You Elect Not to Have It Apply

Once you set up an installment sale, the Internal Revenue Service automatically treats it as an installment sale. For example, the gain on the sale will automatically be spread over the term of the installment sale instead of recognized immediately upon the sale. For our Southwest Gas Holdings clients who do not wish to have the transaction treated as an installment sale, then you need to affirmatively elect not to receive such treatment.

You Cannot Have Installment Sale Treatment for the Sale of Marketable Securities

You cannot have installment sale treatment for the sale of stocks or securities that are traded on established securities markets (e.g., the New York Stock Exchange, the American Stock Exchange, over-the-counter markets). If you do sell marketable securities through an installment sale, then any installment payments to be received in future years are considered to have been received in the year of the sale and will be taxed as such. In other words, you will be taxed on the full amount of the gain from the sale of marketable securities in the year of the sale, even if the payments are spread over a number of years.

Strengths

Shifts Income from High Tax Years Into Low Tax Years

An installment sale allows you to spread the taxable gain from the sale of an asset over a number of payment installments. This allows you to defer the taxable gain from years in which you may be in a high tax bracket to years in which you may be in a lower bracket. You must include a portion of the gain from the sale in income only when you actually receive each payment. With an installment sale, you have the flexibility to shift income from high tax years into low tax years.

Example(s): You own a piece of undeveloped land with a basis of $20,000 that is currently worth $100,000. You are presently in a high tax bracket. You expect to retire from Southwest Gas Holdings in two years and anticipate that you will be in a lower tax bracket at that time. You would like to sell the land to your daughter this year, but you do not want to report the entire gain before your Southwest Gas Holdings retirement. One solution for these Southwest Gas Holdings clients is to structure an installment sale. You can sell the land this year to your daughter, structuring the sale so that you will not start receiving payments until three years after the sale when you will be retired from Southwest Gas Holdings and in a lower tax bracket.

May Help Reduce Estate Taxes

An installment sale transaction is a very effective estate-freezing technique that many of our Southwest Gas Holdings clients have found useful; It's especially effective when the sale is between family members and involves appreciating assets such as real estate or a closely held company. When the asset is sold for full and adequate consideration, only the present value of any unpaid installment payments is included in the seller's estate at the time of death. The value of the underlying asset is not included in the taxable estate of the seller.

Any appreciation in the asset after the time of the sale has therefore been removed from the seller's estate without either gift or estate tax consequences. A further way to reduce the seller's estate is to have the seller gift back part or all of the payments that he or she receives from the buyer.

May Create a Market for a Business

An installment sale may help an owner of a business or other type of property to sell that asset more readily. An installment sale may allow a buyer who cannot afford to purchase the asset outright to spread the purchase price over a number of years.

Example(s): You own a closely held company and would like to retire. Your son works in the business and would like to buy the company. The company has a fair market value of $3,000,000. Your son does not have enough capital to buy the company outright. One solution is to structure an installment sale of the business so that the purchase price can be spread out over a number of years. Your son can then use the cash flow from the company to fund the payments.

Seller May Retain Security Interest In Property Without Jeopardizing Income Tax Consequences

Unlike a private annuity, the seller in an installment sale transaction may retain a security interest in the property sold without jeopardizing the beneficial income tax treatment. In a private annuity, if any security interest is retained by the seller, all of the gains will be taxed at the time of the sale.

However, in an installment sale, the seller may retain a security interest in the property sold and still spread the taxable gain over the term of the installment payments. In an installment sale transaction, the seller may also require that a third party (such as a bank issuing a standby letter of credit) guarantee payment in the case of default by the buyer.

Caution: The IRS and some courts have held that funds placed in an escrow account to secure the interest of the seller are considered to be constructively received and are currently taxable to the seller.

Allows Flexibility and Certainty About Repayment Plan

An installment sale allows for more flexibility and more certainty about the repayment plan than a private annuity. Unlike a private annuity, an installment sale transaction can begin and end whenever the parties desire (as long as one of the payments occurs in a taxable year after the year of the sale). The buyer will also know exactly how long and how much the payments will be at the time of the sale (assuming that the installment payments are not contingent).

With a private annuity, the buyer cannot be sure how long the seller will live and therefore how many payments will have to be made. Furthermore, with a private annuity, the amount of each payment must be actuarially determined and set at a specific amount. With an installment sale, you have some discretion in how the payments will be determined.

Example(s): You would like to sell a piece of artwork to your daughter this year. You expect to be in a very high tax bracket for the next two years. For tax reasons, you would like to defer receiving any payments until at least year three. You can accomplish this goal with an installment sale. You can sell the painting this year and, in the installment sale agreement, specify that payments will not begin until the third year. Furthermore, your daughter will know at the time of the sale exactly how many payments she will have to make.

Buyer May Be Able to Deduct Interest Payments on Installment Sale Purchase

Unlike a private annuity (where no part of the payment is deductible by the buyer), a buyer in an installment sale may be able to deduct interest payments made in connection with an installment sale. Under Section 163(h) of the Internal Revenue Code, a deduction will be allowed for interest incurred in the purchase of a qualified residence, for investment interest to the extent of investment income, and for interest on purchases allocable to a trade or business. No interest deduction will be allowed if the interest is considered personal interest.

Buyer In Installment Sale Gets Stepped-Up (or Stepped-Down) Basis In Property

Unlike a gift, where the done takes the basis (generally, the property's cost) of the donor, the buyer's basis in an installment sale is the purchase price of the property. This may be especially advantageous when the seller has a very low basis in the property and the property has appreciated dramatically. The buyer can use the new stepped-up basis for depreciation (if it is depreciable property) or for income-tax purposes on a sale (if the property is held for two years or more after the sale).

Example(s): You own a piece of land with a basis of $50,000. You sell the land for $150,000 to your daughter in an installment sale. Your daughter's basis in the land is now $150,000. She holds the land for two years and then sells it for $160,000. Her taxable gain is only $10,000. She does not have to pay the tax on the $100,000 gain to which you would have been subject had you sold the land outright. The gain is further amplified if your daughter is in a lower tax bracket than you are.

Seller May Purchase and Be the Beneficiary of a Life Insurance Policy on the Buyer of The Property

A seller in an installment sale may own, pay the premiums on, and be the beneficiary of a life insurance policy on the buyer of the property. The seller can therefore protect against the potential cutoff of payments upon the premature death of the buyer. In fact, in many installment sale transactions, the amount of the payments is increased to allow the seller to purchase such a life insurance policy on the buyer.

That same shift from growing assets to drawing them down applies directly to the pension decisions in front of you at Southwest Gas Holdings. Southwest Gas Holdings maintains an active defined benefit pension plan, meaning eligible employees continue to accrue benefits based on years of service and compensation. If you are eligible for a lump sum payout, IRS Section 417(e) segment rates determine how the future annuity stream converts to a present-value payment - rising rates compress the lump sum, so monitoring the plan's stability period and lookback month is critical before you lock in your election date. The choice between a single-life annuity, a joint-and-survivor option, or a lump sum (where available) is generally irrevocable once made, and timing that decision relative to interest rate conditions can meaningfully affect your retirement income picture.

On the healthcare side, Southwest Gas Holdings provides continued medical coverage to eligible retirees, which can bridge the gap between retirement and Medicare eligibility at age 65 or serve as a supplement to Medicare thereafter. Confirming the service and age requirements for retiree coverage, and understanding your premium contribution, is an important step in building an accurate healthcare cost projection. Coordinating Southwest Gas Holdings's retiree coverage with Medicare Part B and Part D enrollment timing can also reduce duplication and avoid late-enrollment penalties. Connecting your specific Southwest Gas Holdings benefits situation to a comprehensive retirement income plan - and understanding how each component interacts - gives you the most complete picture of what retirement will look like.

Tradeoffs

Present Value of Unpaid Installments Included In Gross Estate of Seller

Unlike a private annuity, the present value of the unpaid installments must be included in the gross estate of the seller. An installment sale can produce especially harsh gift and estate tax results when the seller dies shortly after the sale. With a private annuity, the value of the property sold is not included in the gross estate of the seller because the payments stop at the death of the seller.

This is true even if the seller dies within a short period of time of the sale. However, with an installment sale, if there are unpaid installments still due at the death of the seller, then the present value of those remaining installment payments must be included in the seller's gross estate.

Example(s): You sell your business to your son-in-law in an installment sale. Under the terms of the transaction, you will receive 10 payments of $200,000 each. You die two years later after receiving 2 payments. The present value (using IRS valuation tables) of the remaining 8 payments must be included in your taxable estate. If, however, the transaction was structured as a private annuity, then the present value of the remaining annuity payments is not included in your gross estate.

May Cause a Sizable Portion of Each Payment to Be Considered Interest Income to Seller If a Note Is Used

Typically, in many installment sale transactions, the seller will take back an installment note from the buyer. Unfortunately, when a note is used, a sizable portion of each payment will be considered interest. This interest income will be fully taxable as ordinary income to the seller.

Gift and Estate Tax May Be Due If Property Is Sold for Less Than Fair Market Value

If the fair market value (FMV) of the property sold exceeds the present value of the installment payments to be made, then the seller is considered to have made a gift to the buyer of the difference. If the difference is greater than the annual gift tax exclusion, federal gift and estate tax may be owed. However, any tax may be offset by your applicable exclusion amount (which is $11,580,000 in 2020, $11,400,000 in 2019, plus any deceased spousal unused exclusion amount), to the extent it is available. A tax may also be due if the interest rate on the installment note is below the applicable federal interest rates. The IRS considers the obligation to be worth less than its face value. Your state may also impose a gift tax.

Is Not Allowed for Sale of Listed Securities

The installment sale method does not apply to the sale of marketable securities. Under the Internal Revenue Code, marketable security is defined as any stocks or securities that on the day of disposition are traded on an established securities market. All amounts received from the sale of listed securities are treated as received and taxable in the year of the sale.

Payments Under Installment Sale May End Before the Death of the Seller

Unlike a private annuity, there is no guarantee that the payments under an installment sale will continue until the death of the seller. For our Southwest Gas Holdings clients who are concerned about outliving the term of payments, you should structure the sale as a private annuity.

May Have Adverse Tax Consequences for the Seller When Property Sold Is Subject to a Mortgage

In an installment sale, when the buyer takes the property subject to a mortgage, the amount of the debt in excess of the seller's basis is considered a payment to the seller in the year of the sale, and is fully taxable to the seller in that year.

Example(s): You sell a piece of property to your son. The property has an FMV of $100,000, and your basis in the property is $20,000. The property also has a mortgage of $40,000. Your son buys the property subject to the mortgage (meaning he is responsible for the mortgage payments in the future). You are considered to have received a payment of $20,000 in the year of the sale (in addition to any payments under the installment sale contract). This $20,000 payment is fully taxable in the year of the sale.

Special Rules for Disposition of Property Between Related Parties May Cause Adverse Tax Consequences to Seller

In an installment sale, there are special rules for the disposition of property between related parties. Related parties include brothers and sisters, spouses, ancestors and lineal descendants, and other related entities. The rules are very complicated and may cause the original seller to have unintended income tax liabilities. If an asset is sold to a related party in an installment sale transaction, and the related party disposes of the property before the original seller receives all of the installment payments, then the original seller is treated as if he or she received all of the proceeds from the second sale.

The original seller is then liable for the capital gains tax on the amount that the second disposition exceeds the original seller's basis in the property. However, the gain is limited to the amount that the second disposition exceeds the selling price between the related parties. This rule only applies if the second disposition takes place within two years of the first disposition.

Example(s): You sell property to your daughter for $100,000. Your basis in the property is $50,000. Your daughter sells the property one year later for $115,000. Under the second disposition rule, you are considered to have received the $115,000. However, your reportable gain (for tax purposes) is limited to $15,000 ($115,000 minus $100,000). Furthermore, under this rule, any payments that you receive from your daughter in the future will be tax-free until they equal the $15,000 gain that you have to recognize.

How to Do It

Hire a Competent and Experienced Attorney

A competent, experienced attorney should be hired to draft all the necessary legal documents to set up the installment sale for these Southwest Gas Holdings clients. You may also want to have an experienced tax attorney or tax accountant review the transaction to make certain that you have complied with all of the relevant Internal Revenue Code sections. The Code sections governing installment sale transactions are extremely complex, and you need to be certain to comply with all of the relevant provisions. Otherwise, there may be disastrous income, gift, and estate tax consequences.

For Certain Types of Property, an Appraiser Should Be Hired

If the fair market value of the property selected for the installment sale cannot be readily determined, then an independent, third-party appraiser should be hired to do an appraisal of the property. The amount of the installment payments should be based on the fair market value of the property sold. If the fair market value is not used, there may be gift and estate tax problems.

Buyer And Seller Need to Select Appropriate Property for Installment Sale

The buyer and seller need to decide what property to select before undertaking the installment sale. If the sale is between family members, typically assets that have the potential to rapidly appreciate in the future will be selected. Such assets might include closely held stock, undeveloped real estate, commercial real estate, and other similar types of assets.

From an estate planning standpoint, it makes sense to select assets that you think will appreciate in the future, because once the installment sale has taken place, any future appreciation in the asset will be removed from the seller's gross estate. An installment sale is a very effective way to freeze the value of the seller's estate.

Tax Considerations

Income Tax

Seller's Income Tax Liability on Gain May Be Spread Over Term of Installment Payments

One of the main tax benefits of an installment sale is that the seller may spread the taxable gain over the term of the installment payments. For income tax purposes, each payment will be broken into three parts: (1) a tax-free return of the seller's investment, (2) taxable profit, and (3) taxable interest income. To determine what part of each payment will be a taxable gain, you must determine the gross profit ratio. This is the proportion that the gross profit (selling price minus seller's adjusted basis) bears to the total contract price (amount to be received by seller). Any interest received is separated and taxed as ordinary income.

Example(s): You sell a piece of land to your daughter for $200,000. Your adjusted basis in the land is $100,000. You arrange an installment sale where you will receive $20,000 per year for ten years. The gross profit is $100,000 ($200,000 selling price minus $100,000 adjusted basis). The gross profit ratio is 50 percent ($100,000 gross profit divided by the $200,000 to be received over the life of the installment payments). Therefore, 50 percent of each payment will be a tax-free return of investment, and 50 percent will either be capital gains or ordinary income, depending on whether the property sold was a capital asset or not. (For the sake of simplicity, interest has been ignored in this example.)

The interest Portion of Each Payment, Whether Stated or Imputed, Will Be Taxed As Ordinary Income

The interest portion of each payment is segregated from the principal portion and then taxed as ordinary income. If the interest rate is stated in the contract and is not a below-market rate, the actual interest charged will be taxed as ordinary income to the seller and potentially deductible by the buyer. Often, the installment sale agreement will not specify an interest rate or will have a below-market interest rate. In this case, the tax code imputes interest on each payment using a statutory rate of interest, and compounds the interest semi-annually.

A portion of the payment will then be treated as interest to both the seller and buyer. The interest portion of each payment is taxed as ordinary income to the seller, and the buyer may be able to deduct the interest payments (subject to the same restrictions and limitations on deductibility that apply to all interest payments). The remaining portion of the payment is considered principal, and the gross profit ratio is applied to this portion of the payment to determine what percentage is a tax-free return of investment and what portion is either a capital gain or ordinary income.

Example(s): You sell land to your neighbor for $100,000. Your adjusted basis in the land is $25,000. You set up an installment sale agreement where you will receive ten annual payments of $10,000. There is no mention in the agreement about interest on the unpaid balance. The IRS will impute a statutory rate of interest to the balance and compound it twice a year. Let's assume that $1,000 of the $10,000 annual payment is determined by the IRS to be interest. The seller must then report this $1,000 each year as ordinary income. The gross profit ratio (75 percent in this instance , $75,000 divided by $100,000) is next applied to the remaining $9,000 principal payment. This 75 percent of $9,000 (or $6,750) is considered either a capital gain or ordinary income, and 25 percent (or $2,250) is considered a tax-free return of investment.

Buyer May Be Able to Deduct Interest Portion of Installment Payments

In general, the interest portion of the installment payment is not deductible by the buyer if the interest is considered personal. Interest is deductible by the buyer if the debt is properly allocated to (1) investment activities, but only to the extent of investment income, (2) the conduct of a trade or business, and (3) purchase of a qualified residence.

Caution: Your tax advisor should be consulted before you deduct the interest payments on an installment sale. The rules allowing interest deductions are very complex.

Example(s): You buy your parents' house from them on an installment sale basis. You intend to use the house as your principal residence. The installment sale agreement sets an interest rate on the unpaid balance that is equal to the going market rate for fixed-rate mortgages. You will be able to deduct the interest portion of each installment payment from your income (as long as the acquisition indebtedness does not exceed $750,000) because the debt is allocable to the purchase of a qualified residence.

If the Sale Results In Loss, Installment Sale Treatment Does Not Apply

If the sale transaction results in a loss for the seller, then the seller cannot use the installment sale method to spread the loss over the term of the installment payments. The full loss deduction must be taken in the year of the sale.

Example(s): You own a piece of land with a basis of $100,000. Land prices in the area have been falling in recent years. You sell the land for $60,000 in an installment sale for ten annual payments of $6,000. You are not allowed to spread the $40,000 loss over the ten-year term of the installment sale. Rather, the entire $40,000 loss must be deducted in the year of the sale.

Installment Sale Treatment Does Not Apply To Sale of Listed Securities

Installment sale treatment is not available for the sale of securities that are traded on established securities markets (e.g., the New York Stock Exchange, the American Stock Exchange, over-the-counter markets). The entire gain from the sale of the securities must be recognized in the year of the sale.

Example(s): You sell $100,000 worth of IBM stock to your grandson in an installment sale. Your basis is $30,000, and the $100,000 will be paid in ten installments of $10,000 each. Your entire gain of $72,000 must be reported in the year of the sale. You are not allowed to spread the gain over the term of the installment payments.

Installment Sale Tre